chapter 19 quantity theory, inflation and the demand for money · 2019. 10. 26. · quantity theory...

Chapter 19

Quantity Theory, Inflation and the

Demand for Money

© 2013 Pearson Education, Inc. All rights reserved. 19-2

Demand for money

Monetary theory: the effect of money on the economy (i.e., the role of the money supply in determining the price level and total production of goods and services (aggregate output) in the economy

• The supply of money is an essential element in understanding how monetary policy affects the economy.

• Monetary theory suggests the factors that influence the quantity of money in the economy. As expected, another essential part of monetary theory is the demand for money


Evolution of the theories of the demand for money:

• the classical theories : Irving Fisher, Alfred Marshall, and A. C. Pigou.

• Keynesian theories of the demand for money.

• Milton Friedman’s modern quantity theory.

• A central question is: whether or to what extent the quantity of money demanded is affected by changes in interest rates. Because this issue is crucial to how we view money’s effects on aggregate economic activity, we focus on the role of interest rates in the demand for money


Quantity Theory of Money

M = the money supply

P = price level

Y = aggregate output (income)

PY aggregate nominal income (nominal GDP)

V = velocity of money (average number of times per year that a dollar is spent)

V PY

M

Equation of Exchange

M V PY

Ve l o c i t y o f M o n ey a n d T h e E q u a t i o n o f E xc h a n g e : I r v i n g F i s h e r ( 1 9 1 1 ) : it examines the link between the total quantity of money M (the money supply) and the total amount of spending on final goods and services produced in the economy P Y.


Quantity Theory of Money (cont’d)

• Ve l o c i t y o f mo n ey : is the average number of times per year that a dollar is spent in buying the total amount of goods and services produced in the economy.

• E xa mp l e : if nominal GDP (P Y ) in a year is $5 trillion and the quantity of money is $1 trillion, velocity is 5, meaning that the average dollar bill is spent five times in purchasing final goods and services in the economy.

• The equation of exchange thus states that the quantity of money multiplied by the number of times that this money is spent in a given year must be equal to nominal income. (an identity—a relationship that is true by definition).

A s s u mp t i o n s :

1. Velocity fairly constant in short run and in the long-run it depends on the technology development and the habits of payments in the society.

• This assumption turns the identity to a theory.



• Demand for money: To interpret Fisher’s quantity theory in terms of the demand for money…

Divide both sides by V

When the money market is in equilibrium

M = Md

Let

Because k is constant, the level of transactions generated by a fixed level of PY determines the quantity of Md.

The demand for money is not affected by interest rates

PYV

M 1

Vk

1

PYkM d


Quantity Theory of Money (cont’d) From the equation of exchange to the quantity theory of money

– Fisher’s view that velocity is fairly constant in the short run, so that , transforms the equation of exchange into the quantity theory of money, which states that nominal income (spending) is determined solely by movements in the quantity of money M

• Fisher’s quantity theory of money suggests that the demand for money is purely a function of income, and interest rates have no effect on the demand for money

P Y M V


Y


Figure 2 Annual U.S. Inflation and Money Growth Rates, 1965–2010

Sources: FRED, Federal Reserve Economic Data, Federal Reserve Bank of St. Louis; Bureau of Labor Statistics, http://research.stlouisfed.org/fred2/categories/25; accessed September 30, 2010.


Keynesian Theories of Money Demand Keynes’s Liquidity Preference Theory (1936):

The General Theory of Employment, Interest, and Money

• Why do individuals hold money? Three Motives

1. Transactions motive • individuals hold money because it is a medium of exchange that can be used to

carry out everyday transactions. This component of the demand for money is determined primarily by the level of people’s transactions. These transactions are proportional to income. So, this component is proportional to income.

2. Precautionary motive • people hold money to deal with an unexpected need. For example with an

unexpected bill, say for car repair or hospitalization. Benefit from some opportunities like buying goods on sale. if you are not holding precautionary money balances, you cannot take advantage of the sale.

• It is determined primarily by the level of transactions that they expect to make in the future and that these transactions are proportional to income. So, this component is also proportional to income.


Keynesian Theories of Money Demand

3. Speculative motive (Liquidity Preference) people choose to hold money as a store of wealth

• However wealth is tied closely to income, the speculative component of money demand would not be related only to income. The decisions regarding how much money to hold as a store of wealth depends also on interest rates.

• Keynes divided the assets that can be used to store wealth into two categories: money and bonds.

• Why would individuals decide to hold their wealth in the form of money rather than bonds?

• People want to hold money if its expected return was greater than the expected return from holding bonds.

• Keynes assumed that the expected return on money was zero because in his time, unlike today, most checkable deposits did not earn interest.

• For bonds, there are two components of the expected return: the interest payment and the expected rate of capital gains.


Modern quantity theory of Money (Milton Friedman)


• Permeant income represents wealth and is defined as: the weighted average of expected future income.

• It is the main explanatory variable in the demand for money function while interest rate plays a secondary role in the function

• Current income is the income in current period

chapter 19 quantity theory, inflation and the demand for money · 2019. 10. 26. · quantity theory...

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